Extreme Market Volatility Passes Munis By - Municipal Bond Update May 10, 2010

MARKET UPDATE

Market volatility makes near-term trends unpredictable.

RECOMMENDATION

Total return and income investors should take care this week as potential Treasury losses imply some downdraft on municipals. Buyers likely benefit from waiting at least another week before putting money to work, although prospects at the front of the curve are likely strongest for those needing to invest cash immediately. Relative value buyers should find great opportunity almost anywhere, but trades up front may also be the ripest. Issuers should back off for a week if possible.

INVESTING STRATEGY

Finding new ways and reasons to talk down states and local governments may be excellent business for hedge funds and their dealers right now; however, we do not believe this is a sustainable trade in its own right (meaning outside of a long hedging context).

SUMMARY

Last week’s extreme volatility in Treasury prices, equity prices, sovereign contagion and rescue, and employment generally swept by the municipal market. By not changing much, municipals were left appearing substantially cheaper versus Treasuries, and perhaps riskier versus the for-now bailed out European sovereigns. Still, the market showed real strength moving a large and up-sized California loan to retail investors with multiple yield cuts, and Build America Bond demand remains solid. These successes were also despite additional rounds of “skunk the muni” by several hedge fund types; we re-emphasize that, while challenges remain to policymakers in the near– and long-terms, there is so far no evidence of an imminent collapse in state and local credit nor a systemic trigger to such an event. Still, default statistics did spike last week, but this was widely expected as almost all Florida dirt deals have a payment date May 1 and many continue to lack resources to pay. We also discuss what will likely be a new phase in the regulation of municipal securities, with not only the SEC but also the IRS likely to deploy post-ARRA resources to address perceived market inefficiencies/inequities.